Is the IRS “failure to file” penalty discharged in bankruptcy?

A taxpayer can discharge an IRS “failure to file” penalty assessed per 26 U.S.C. §6651(a)(1) for failure to file a tax return.  A taxpayer has two choices.

Option 1: A taxpayer with income can choose to file a Chapter 13 bankruptcy case and establish a repayment plan addressing all creditors, including the IRS.  The IRS “failure to file” penalty would be treated as an unsecured claim and paid on the same level as credit card debt, medical debt, and personal loans.  The IRS and other unsecured creditors could receive as little as 10 cents for every dollar owed and less in some jurisdictions.  At the completion of the repayment plan, any unpaid unsecured debt would be discharged and the IRS penalty obligation eliminated per 11 U.S.C. §1328(a).

Option 2:  A taxpayer without income or with insufficient income to fund a Chapter 13 bankruptcy case, instead, could file a Chapter 7 bankruptcy case.  No repayment is required in a Chapter 7 case and the IRS could be entitled to distribution from property of the bankruptcy estate on a prorate basis with all other unsecured creditors.  However, there is typically no property to distribute in a normal Chapter 7 case.

At the conclusion of a Chapter 7 case the taxpayer would receive a general discharge of debts pursuant to 11 U.S.C. §727(a).  This general discharge does not necessarily cover the IRS’ “failure to file” penalty because 11 U.S.C. §523(a)(7) creates an exception for penalties payable to a governmental unit. So a deeper analysis is required.

The exception to the bankruptcy discharge applies “to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit.   11 U.S.C. §523(a)(7).  The IRS is clearly a governmental unit.  But this exception to discharge is limited when it relates to a “tax penalty.”

Section 523(a)(7)(B) provides that the exception to discharge does not apply and the IRS tax penalty is discharged if it was “imposed with respect to a transaction or event” that occurred more than three years before the bankruptcy petition.  Therefore, a taxpayer may not be discharged of an income tax penalty imposed less than three years before the bankruptcy petition is filed.  But, a taxpayer would be discharged of an income tax penalty imposed more than three years before the bankruptcy petition is filed.

So the question becomes: “when is an income tax penalty “imposed with respect to” a failure to file penalty imposed by the IRS pursuant to 26 U.S.C. §6651(a)(1)?”  That issue was addressed in  In re Wilson, 527 B.R. 635 (Bankr. N.D.CA 2015).  In Wilson, a taxpayer was granted a filing extension for his 2008 tax return from April of 2009 to October of 2009.  That taxpayer did not file the return until 2011.  The taxpayer filed for bankruptcy in July of 2012, which was more than three years after the April 2009 filing deadline and less than three years after the October 2009 filing deadline.

The taxpayer argued that the penalties should be discharged because they were imposed with respect to his 2008 tax liability, due April of 2009, and therefore were more than three years old when he filed his bankruptcy.  The IRS argued that the penalties should not be discharged because they were imposed in October of 2009, when the taxpayer missed his extended filing deadline, and were therefore less than three years old when the bankruptcy petition was filed.

The Wilson court agreed with the taxpayer and found that §523(a)(7)(B) is to be applied according to its plain meaning, so that a penalty imposed on unpaid taxes accruing more than three years before the filing of the bankruptcy petition is dischargeable.  Interestingly, the court stated that “penalties imposed on account of failure to file a return are computed by reference to the tax obligation itself,” and not by reference to the filing date. Id. at 638.

Practice Pointer:  A tax professional should have counseled the taxpayer to postpone the bankruptcy case filing date from July of 2012 to a few months later and after October 16, 2012 to ensure the case was filed more than three years after the due date.  The tax professional would have saved the cost of litigation had the taxpayer strategically timed the bankruptcy filing date.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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